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3 Sector ETFs to Profit from Rising Rates

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The stock market suffered its worst sell-off of the year yesterday as investors feared that the Fed may begin ‘tapering’ its unprecedented monetary support sometime later this year. Growing concerns about China’s economy added to the turmoil.

There is no disagreement that the Fed’s QE has been the main driving force behind the massive stock rally that we saw in recent months and thus the market’s reaction to Bernanke’s remarks hinting that the Fed could wind down the QE program came as no surprise. (Read: QE tapering could make these bond ETFs winners)

However investors should remember that rising interest rates are in general good for stocks as they suggest an improving outlook for the economy. Further bonds lose value when rates rise and so more money will flow into stocks from bonds.  (Read: Spin-Off ETF continues to beat SPY)

Rising rates are a risk to stocks only when the central bank raises rates to battle inflation but inflation doesn’t seem to be becoming a concern for the Fed any time soon.

While the stock market will mostly likely continue to be volatile in the coming weeks as investors try to digest new information and begin to reposition their portfolios, this may be the right time to look at some of the sector ETFs that will benefit from the rising rate scenario.

Financial ETFs

Banks are in the best position to benefit in the current environment of rising longer-term rates and steepening yield curve. Remember, short term rates are going to stay at ultra-low levels as long as the Fed maintains its fed funds rate near-zero levels but long-term rates will continue to rise in anticipation of slow-down in the Fed’s bond buying program.

A steepening yield curve means that banks can borrow at very low rates and lend at much higher rates i.e. it improves banks’ net interest margin. (Read: 3 New ETFs you should not ignore)

U.S. banks now have much stronger balance sheets and their earnings picture continues to improve. Per Zacks estimates, finance sector earnings will increase 19.1% during the second quarter from the prior-year quarter.

Rising interest rates could however slow down mortgage origination as well as refinancing activities, but mortgage rates are still very low by historical standards and only a steep rise from here will hurt banks. 

Vanguard Financials ETF (VFH - Free Report)

With an expense ratio of just 19 basis points, VFH is a cheap way of getting a diversified exposure to financial services companies.

Launched in January 2004, this ETF is now home to $1.5 billion in assets. The product holds 515 stocks in its basket with highest allocations to Wells Fargo, J P Morgan and Citigroup. The fund's dividend yield is 1.9% as of now.

VFH is currently a Zacks Rank #1 (Strong Buy) ETF.

Consumer Discretionary ETFs

Consumer discretionary stocks have been doing pretty well in recent months as the labor market showed clear signs of healing. Further rising housing market and surging stock market added to the “wealth effect”, resulted in rising consumer confidence. Lower gasoline prices have also been helping consumers.

Further improvement in the economic outlook and low inflation will continue to benefit consumer discretionary sector. Research also shows that consumer discretionary stocks have benefitted in the rising rate scenario.

SPDR S&P Retail ETF (XRT - Free Report)

XRT was launched in June 2006 and has amassed more than $950 million in assets so far. The fund holds 97 companies in its basket and comes with a low cost  of 35 basis points a year.

Its equal weight focus also ensures that the risk is pretty spread out. This product also has a top Zacks ETF rank, suggesting that it is poised to outperform in the near- to mid- term. The fund has performed very well so far in 2013, with about 25% return year-to-date.

Insurance ETFs

Insurance companies benefit from rising interest rates as they are able to earn higher returns on their investment portfolio. Further insurance rates have been going up of late and the cycle is expected to continue for the next few years.

Rising interest rates, favorable pricing and growing demand are going to be positive for the insurance industry. Insurance industry looks well poised to outperform in the coming months from the Zacks industry rank (9 out of 265) perspective too.

Dow Jones U.S. Insurance Index Fund (IAK - Free Report)

IAK tracks the Dow Jones U.S. Select Insurance Index. The product made its debut in May 2006 and has attracted $118 million in asset so far.

It currently holds 66 stocks in its basket and charges investors 47 basis points a year in fees. AIG, MetLife and Prudential Financial are the top three holdings while Property & Casualty are Life Insurance are the top sectors in terms of exposure.

The yield is moderate at 1.5% a year, but its performance has been solid with a 23% return year-to-date. The ETF currently has a Zacks ETF Rank of ‘3’ or hold, with a medium risk rating.

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